The Government Budget and the Public Debt 1 Introduction: The Debate over the U.S. Budget Deficit The long-run aspects of fiscal policy Monetary policy should be used in stabilizing GDP at the desired level of output Short-run stabilization focus Fiscal policy is responsible for the level of real interest rates Long-run economic growth focus 2 1
Long-Run effects of Fiscal Policy on Economic Growth and Welfare Introduction The key link between fiscal policy and long-run growth comes through the effect of a persistent budget deficit in reducing the national saving rate A key aspect of this is society s rate of time preference 3 Long-Run effects of Fiscal Policy on Economic Growth and Welfare (continued) Raise Saving or Do Nothing?» Figure 11-1 Deciding on current versus future consumption An economy saves too little if the rate at which individuals discount future consumption is less than the rate of return on private investment Real rate of return approximately 12% Real interest rate approximately 4%» Implications for stock and bond markets 4 2
Figure 11-1 Two Alternative Paths of Consumption per Person 5 Long-Run effects of Fiscal Policy on Economic Growth and Welfare (continued) National Saving, Economic Growth, and the Government Budget Deficit National saving is the sum of private and government (dis)saving Private saving is relatively stable Government (dis)saving is highly volatile Government deficits reduce national saving Which reduces investment and economic growth 6 3
Long-Run effects of Fiscal Policy (con t) National Saving, Economic Growth, and the Government Budget Deficit (continued) How the deficit is reduced is just as important as whether it is reduced In reducing deficits, policy-makers must be careful not to also reduce private saving» Consumption taxes not income taxes In reducing deficits, policy-makers must be careful not to also reduce investment» Public vs. private investment 7 The Future Burden of the Government Debt Introduction Any burden of extra government debt depends on whether it is financing government expenditures on investment goods or for consumption goods How do we classify defense expenditures Government investment projects should be financed by deficit spending Those who receive some the future benefits will help pay some of the costs 8 4
The Future Burden of the Government Debt True Burden of the Debt The true burden on future generations is created by government deficit spending that pays for goods that either yield no future benefits, or yield benefits less than their social opportunity costs Debt Owed to Foreigners International financing of domestic debt does not change the burden analysis» Although short-term stimulus to the economy is less 9 Will the Government Remain Solvent? Introduction The key is whether the debt-to-gdp ratio is stable D / ( P * Y ) How large can the deficit be to keep this ratio constant? The growth of the debt-to-gdp ratio must be 0 d - ( p + y ) = 0 or d = p + y or d * D = ( p + y ) * D 10 5
Will the Government Remain Solvent? Introduction (continued) The Debt-to-GDP ratio remains constant if the deficit is equal to the outstanding debt time the growth rate of nominal GDP Defines the allowable deficit Is there an optimum debt-gdp ratio? 11 Will the Government Remain Solvent? The Solvency Condition Can the government finance its interest bill by increasing its deficit? The government can meet its interest bill through debt financing without increasing the debt-gdp ratio only if the economy s real growth rate equals or exceeds its real interest rate The Real-World Solvency Condition in the 1990s 12 6
CASE STUDY: Historical Behavior of the Debt-GDP Ratio Since 1790» Figure 11-2 Wars and Depressions The New Regime of the 1980s and 1990s 13 Figure 11-2 The Ratio of U.S. Government Debt to GDP, 1790 1998 14 7
Sources of the Deficit and the Debate over the Size of Government Do Official Deficit Measures Exaggerate the Problem? The real burden is less than the nominal burden One time deficit financing events Combined with state and local government budgets Current versus capital budget 15 Sources of the Deficit and the Debate over the Size of Government (continued) Behavior of Revenue and Expenditure Ratios» Figure 11-3 Categories of Spending» Figure 11-4 16 8
Figure 11-3 Federal Government Revenues and Expenditures as a Percent of GDP, 1960 96 17 Figure 11-4 Components of Federal Government Expenditures as a Percent of Natural GDP, 1959 96 18 9
Alternative Views of Fiscal Policy: Supply- Side Economics Supply-Side Arguments for Reagan Tax Cuts Introduction Tax rates are too high Government sector is too large Three important claims Income taxes reduce incentives to work and save Increasing the after-tax rewards to work and save will create significant increase in work and saving Significant increase in work and saving will reduce the budget deficit 19 Alternative Views of Fiscal Policy: Supply- Side Economics (continued) Supply-Side Arguments for Reagan Tax Cuts Response of Work Effort and Saving Response of Productivity Growth The Laffer Curve» Figure 11-5» Shape and peak is completely arbitrary 20 10
Figure 11-5 The Laffer Curve 21 Alternative Views of fiscal Policy: The Barro-Ricardo Equivalence Theorem Introduction Assumes rational expectations Discretionary fiscal policy is completely ineffective because tax cuts will be offset by higher savings rather than increased consumption Higher future taxes are seen as completely equivalent to lower current taxes» This is why it is called the equivalence theorem Inter-generational transfers 22 11
Alternative Views of fiscal Policy: The Barro-Ricardo Equivalence Theorem Criticism of the Equivalence Proposition Decision horizons Discount rates Evidence from the 1981 Tax Cuts 23 Pros and Cons of a Balanced Budget Amendment The Case for Budgetary Balance Basic economic argument: boost economic growth However, only about 20% of the reduction in the deficit will result in increase private investment» Some decline in private savings» Some decline in foreign investment 24 12
Pros and Cons of a Balanced Budget Amendment (continued) The Case for Budgetary Balance (continued) Channel for boost economic growth» Lower interest rates (although small)» No effect on inflation;monetary policy stabilizes GDP» Economic growth accelerates (but not by much) Cost to deficit reduction» Reduced government spending and/or» Higher taxes 25 Pros and Cons of a Balanced Budget Amendment (continued) The Case for and Against an Amendment The Case for an Amendment The political process is incapable of delivering a balanced budget The Case against an Amendment Eliminate automatic stabilization Benefits are minimal Likely boost government consumption at the expense of government investment 26 13
Conclusion: The Debate between the Termites and Pussycats Termites believe the deficit is insidious Higher interest rates Less investment Slower productivity growth Pussycats believe the deficit is benign Government spending is beneficial Debt-to-GDP ratio can be stabilized Provides restraint on government spending 27 14